The table below contains information on two shares: X and Y. R₀ is the realized one-year holding period period in the year just ended. E(R₁) is the forecast return for the next year based on the performance of the company. The market risk premium is 8% and risk free rate is 2%.

Shares: R0 : ER(1) : Beta : sd

x 13% 15% 0.9 21%

y 14% 19% 1.3 23%

1 For a new investor who only wants to invest in one of these two shares, which share should be picked? Explain. (2 marks)

For an investor who has already been holding a well-diversified portfolio and only wants to add more shares if doing so will improve portfolios alpha. Should this investor invest in X or Y? Or both? Or neither? Explain. (2 marks)

An investor has constructed a risky portfolio Z by combing X and Y. Portfolio Z has an expected return of 16% and standard deviation of 22%. If the investor wants to further combine portfolio Z with the risk-free asset to maximize expected return while having a standard deviation not higher than 18%, what should be the weights of X, Y and the risk free asset? (use E(R₁) in the table as the forecast expected return for share X and Y for determining share X and Y weights in portfolio Z) (4 marks)

If CAPM holds, how are investors expected to trade shares X and Y based on the values you have calculated in part b)? What will happen to the price of X and Y if there is no new information to be revealed to market? (2 marks)